September 14, 2011 / 4:50 PM / 6 years ago

Fed cutting rate on reserves weighed

NEW YORK (Reuters) - Investors and traders are rethinking whether the U.S. Federal Reserve might reduce the interest it pays banks on their excess reserves as another tool to stimulate lending and to avert another recession.

While Fed Chairman Ben Bernanke and other Fed officials have mentioned such a move as a policy option, investors and traders had placed a low probability that the U.S. central bank would use it because it risks cutting bank profitability and causing turmoil in money markets.

That prevalent view was challenged after Goldman Sachs economists issued a report late Tuesday saying they see “a greater than 50 percent chance” that the Fed would trim the interest rate it pays on excess bank reserves, which is currently at 0.25 percent.

Banks were holding $1.7 trillion in excess reserves with the Fed at the end of August, according to Fed data.

Goldman economists predict the Federal Open Market Committee could reduce that rate to 0.10 percent.

“It’s on the table. They keep mentioning it as a possibility,” said James O‘Sullivan, chief economist at MF Global in New York.

U.S. short-term interest rates futures rose on Wednesday as traders reconsidered the chances that the Fed might reduce the interest rate on excess reserves.

The three-month rate on overnight indexed swaps, which gauges expectations on the Fed’s policy rate, fell to 0.0550 percent, just a hair above the recent low of 0.0525 percent in early August.

With the Fed’s next policy meeting a week away, there are growing expectations that the U.S. central bank will announce a program to buy long-dated Treasuries in an attempt to lower mortgage rates and other long-term borrowing costs.

The need to revive “Operation Twist,” which was first undertaken in 1961, has been questioned by some investors.

Another perceived risky move from the Fed, to manipulate the short end of the U.S. yield curve, might not be worth the gamble since it would hurt the fragile banking sector, some analysts said.

“Why would the Fed double down now when they have been cautious up till now,” said Steve Ricchiuto, chief economist at Mizuho Securities USA in New York

Lowering the interest rate on banks’ excess reserves with the Fed would further erode banks’ bottom line if the Fed also engages in “Operation Twist,” which would lower the interest margins banks earn on their loans and securities.

“It’s a double whammy for banks, and banks are at the heart of the problem,” Ricchiuto said.

Goldman economists raised other shortcomings of the Fed cutting the interest rate on reserves. They said banks could levy fees on customers to make up for reduced interest income.

Such a move, they say, would also make it harder for the $2.6 trillion U.S. money market mutual fund industry to recoup their operating costs as its earnings have suffered in the current near-zero rate climate orchestrated by the Fed.

Distress on money funds could disrupt money markets, which exacerbated the global credit crunch in late 2008.

Still, Goldman economists see a better-than-even shot that the Fed’s rate-setting committee would make such a move.

Cutting the interest rate on excess reserve is “clearly an imperfect option with very limited impact on interest rates, but with a lack of other tools and an unwillingness to expand the balance sheet (at least for now), we believe a majority of the committee could support it,” they wrote in the note.

Editing by James Dalgleish

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